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How Might Ben Bernacke’s Recent Interest Rate Predictions Affect your Retirement Portfolio?
James Lange, CPA/Attorney
Guest: Michael J. Jones, CPA
Please note: Some of the events referenced in our audio archives have already passed. Please check www.retiresecure.com for an updated event schedule.
|Click to hear MP3 of this show|
- Introduction to Guest – PJ DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx
- Picking the Right Investments
- Self Directed IRAs
- Staying Steadfast Even in Fluctuating Times
- The Direct Profitability Premium and How It Can Benefit You
- What Should I Base my Investment Choices On?
- Emerging Markets
- How to Best Judge What Your Investments Might Do
- What Lange Financial Group and Its Affiliates Can Do For You
David Bear: Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks. I’m David Bear with James Lange, CPA/Attorney and author of two best-selling books, Retire Secure! and The Roth Revolution: Pay Taxes Once and Never Again. The recent roller coaster ride of the stock and bond markets is a short-term reaction to Federal Reserve Chairman Ben Bernanke’s interest rate speculations. But over the longer term, how will interest rate changes impact your retirement portfolio? Today’s in-studio guest is P.J. DiNuzzo, a nationally recognized expert in investment management. P.J. has appeared in numerous business publications and television shows. Rated a 5 Star Advisor by Paladin Registry investor watchdog, he ranks among the top one percent of America’s more than 800,000 investment advisors. P.J. was approved as one of the first 100 Dimensional Fund Advisors in the early 1990s. His firm, DiNuzzo Index Advisors, has been ranked among the top 500 investment firms in the country. Jim and P.J. will explore a variety of issues today, including a look at Fed chairman Bernanke’s recent assessments about future interest rates and how they may affect your retirement portfolio. It’ll be an interesting and informative hour, and listeners, since our show is live, you can join the conversation. Call the KQV studios at (412) 333-9385 with your questions and comments, and with that, I’ll say hello, Jim and welcome, P.J.
Jim Lange: Welcome, P.J.
P.J. DiNuzzo: Hey, good afternoon.
Jim: First, before we get into the meat of the program, I do have to present full disclosure. Usually, when I have a guest, I don’t have any real direct financial interest in the guest. Many times, they are national experts who have written books and I sometimes give a plug for their book, but frankly, I don’t have any direct connection in whether you buy a book or whether you don’t buy a book. I don’t get a nickel more or less. That is not true with P.J. DiNuzzo. P.J. and I have an arrangement whereby if people come to my office and we have a discussion regarding retirement planning, estate planning, tax preparation, tax planning and investments, whereby if somebody is the appropriate fit and they’re also interested in investments, I then usually, or at least very often, recommend, if it’s a good fit, that they actually invest their money with P.J. DiNuzzo at DiNuzzo Index Investments, and P.J. and I do have a fee sharing arrangement. So, I am not independent with P.J. and it is only fair for me to say that before we actually get in to tonight’s meat of the program, that he is not completely independent, and I do have a financial interest in the work that we do together. And, basically, the arrangement is our office will do the retirement planning, the estate planning, the tax planning, we meet with people and we run numbers, and we do Roth IRA conversion recommendations, and Social Security recommendations, and then we meet people, at least on an annual basis, to do that type of strategic work. Then, P.J. actually does the money management using low-cost index funds called Dimensional Fund Advisor funds and he does what I believe is a fabulous job. He is the most detail-oriented financial advisor I have ever seen in terms of literally doing… you’re doing your budgets down to the cable bill in order to help him do a series of asset allocation portfolios. You don’t get one portfolio, you get multiple portfolios. Where are you going to get your money, years one or two? Well, that’s gonna be a lot more bonds and fixed income than, say, the one that’s going to be seven to ten years out, which is going to be more long-term. So, anyway, he does a fabulous job, but before we get started, fair warning, I am not independent. P.J., Ben Bernanke has basically come out and said that he does not want to continue supporting low interest in general, or indefinitely, and, in addition, with the low interest rates, you know, we’re talking like one or two percent on a lot of government, and even private, bonds. What is the motivation for people to stay in bonds or a fixed income account?
P.J.: Yeah, Jim, the motivation would be discipline. When we take a look at our strategies, you know, one of the benefits that you had mentioned earlier was the index strategies we have. We’ve got an 85 year track record going back to 1926-1927. So, if the audience can think, what would you like to have when you would invest with an investment manager? Would you like a track record? The answer, of course, would be yes. Would you like a short term, intermediate term or long term? So, to have an 85-year track record, we know what all of our U.S. asset classes have done, U.S. large stocks, large value, small value, and especially all of our fixed income, all of our bonds, our one-year, two-year, three, five, etc. And to take a look at…we’ve been through periods of world wars, inflation, deflation, and stagflation. Now, of course, we’re maintaining, on average, a short-term bond index position, so to speak, so even with this recent rise in interest rates with Chairman Bernanke’s the QE3, the tapering comments and conversations have gone on, our short-term bond indexes have held very steadfast and we’re still in the black at this point. A lot of people, as you and David had mentioned, are sort of heading for the high grass right now because they were searching for yield, either through a longer term. We’ve seen a lot of people going for 15, 20, 25 and even 30-year bonds to get a higher yield, or they’ve been going for a lower credit quality, and those bonds are still having the same challenge of a lot of capital depreciation with this recent rise in interest rates.
Jim: Well, that sounds a little bit like a ‘stay the course’ idea. Does that mean that you’re not reacting to the financial news of the day?
P.J.: Yes, that would be…we’re steadfast. We haven’t made any trades in the portfolios. We’re maintaining that short-term bond portfolio, about two to three year average maturity in all of our clients.
David: Well, you know, I see that we have a call on the line from Mike from Shaler. He has a question about a self-directed IRA.
Mike: Good evening, gentlemen. Yeah, I do.
Jim: Good evening, Mike.
Mike: Hello. I wanted to ask you all about any pitfalls that might exist with self-directed IRAs. I had most of my money in equity mutual funds through my IRAs from previous employers, and, you know, I basically…I’m a twenty-year professional, so I went through a couple of market cycles here, and with all the QE and extra money on the table, these assets, I’m afraid, won’t have anything to back them up later in this year. And what I’ve done in May…
Jim: Mike, I hate to cut you off, but can you ask your question?
Mike: Oh yeah. What are the pitfalls for self-directed IRAs compared to the other equity mutual funds?
Jim: Well, I’ll take it, and then maybe I’ll give P.J. a shot. A self-directed IRA is, to me, nothing other than you are directing the IRA and that you can put it in anything you want, whether you pick stocks, individual stocks or bonds or mutual funds or Vanguard or wherever it might be. For the do-it-yourselfer, let’s say that you are a do-it-yourselfer and you like to do the analysis, and you like to do the investing yourself, being a self-directed investor and having a self-directed IRA is a reasonable choice for some people. There are probably a lot of good reasons not to. For me, if I was self-directed, personally, I would probably be thinking about a well-diversified portfolio in the Vanguard world. Obviously, we think that the combination of P.J. and I provide a lot more value, but for a lot of people who don’t want to pay any advisor anything no matter what, having a self-directed IRA, perhaps using low-cost index funds in Vanguard is probably a reasonable idea. P.J., what would you say to somebody with a self-directed IRA?
P.J.: Yeah, Mike, I was just thinking with your definition of a self-directed, were you thinking about something where you would take your IRA and you would place it potentially in a real asset, such as a real estate investment?
Mike: In the last couple of years, I’ve had some changes in life, and I really felt betrayed back in 2009 with all the shenanigans on Wall Street, and I figure real estate, especially single family housing, is a great value. I’ve actually bought a couple of properties through my self-directed IRA and, you know, it’s something I’m new at. I’m used to buying all the Vanguards. I have Vanguard in my company 401(k). Obviously, with a 401(k), you can’t touch that money, but what I’m really looking to do is even move more money out of equities and put even more money in real estate in this period of time.
Jim: Okay, all right. P.J. picked up what you were talking about, a self-directed. P.J., why don’t you give him an opinion, and then I will too.
P.J.: Yeah, Mike, the way that we explain this to our clients is what we’re really talking about here is two different things. We’re talking about wealth management versus…if you want to think about a self-directed IRA, almost as if you…think of this as if it was non-qualified assets, after tax assets. We were talking with a client, and they say, “You know, I really need these assets to be able to meet my retirement, to build my personal pension plan for myself and my family, but I’m thinking about taking these and buying a restaurant, buying real estate, whatever it may be.” You’re now in the field of being in business. So, we just tell clients that you need to think that through. You’re really in a field of being in business with these assets, with the real estate assets, and it’s a little bit too long of an answer for the show, but most of those end up worse than people really would estimate that they would. What we would say in 2008 and 2009, and I hear what you’re saying with the betrayal, but at the end of the day, what really happened was most people were too aggressively invested when it went to 2008 and 2009, and all I can tell you in summation, before we hand it over to Jim, that anyone who’s bet against our country for the last two hundred plus years has ended up on the losing side of the trade.
Jim: I actually have a slightly different opinion, although I agree with everything P.J. said. To me, if you’re interested in investing in real estate and you like the idea of, let’s say, a single building, I would probably do that outside the IRA. You don’t have any restrictions. You don’t have all these internal fees. And the other thing is, you can deduct your depreciation, and typically, those deals, even if they’re a cash break even, are a tax loss, and if they’re in the IRA, they don’t do you any good. They only do you some good in an IRA years later when they’re cash positive. One of the things that I fear about the self-directed IRAs is that they are sold by people who are selling it to investors who don’t have the after-tax dollars to pay for it from outside of their retirement plan. So, the reason they buy it inside their retirement plan is because that’s the only place they have the money. Personally, I would agree with P.J. Your retirement plan is for your retirement, and if you want to have a business venture of buying real estate, then I would do it with after-tax dollars and then get the tax benefits of that. There are a few self-directed IRA ideas that might make sense. Let’s say you have this killer profitable company that you have an interest in that you’re not managing and you buy some with your IRA and then, you convert it to a Roth IRA and then all those proceeds are income tax-free, but that’s the great exception. I would…I can’t tell you…there’s a guy in Florida who is selling these, you know, self-directed IRA lots and things like that, and he wanted me to get involved, and I didn’t have any interest at all. But thanks for your question, Mike.
P.J.: Thank you, Mike. Great question.
Jim: All right. So, anyway, you were saying that you don’t get flustered with, let’s say, the news of the day and that you don’t automatically make big changes in your portfolio based on tomorrow’s news or yesterday’s news or what is going on exactly right now. Is that right?
P.J.: Yeah. We’re building what we refer to as ‘all weather portfolios,’ and again, especially on the bond side of the portfolio, that’s been from the University of Chicago Nobel Laureate Professor Eugene Fama, Sr. Keep the risk reward trade on the short-term of the yield curve, three, four, maybe five years. So, right now, as I said, our portfolio has basically been unfazed. But the audience needs to remember: if you’ve got a ten-year portfolio, even just a ten-year bond, there are twenty and thirty year bonds out there. If you have a ten-year duration in your portfolio and, let’s say, for example, the ten-year U.S. Treasury were to increase by one percent, your face value’s gonna take a ten percent hit. So, that’s what’s really fazing a lot of people. That’s what happened in the market the last couple of weeks.
Jim: All right. Say that again because that’s an important concept. So, let’s say that I have a bond that has a two percent face value and then let’s say the rest of the market goes…the interest rates go up or inflation starts coming in and these bonds might go up to four percent. What will happen to the value of my two percent bond?
P.J.: Yeah, what the audience needs to think of, Jim (that’s a great point) is that if the audience thinks that if you have a bond right now that’s yielding two percent…well, let’s even take a real life example, Jim. I mean, the ten-year treasury a couple of months ago was yielding 1.6% and change, and recently, it just hit 2.6% last week.
Jim: All right. So, it went up one point?
P.J.: So, it went up one point, but on a percentage basis, one of the largest increases in a short period of time in history. So, if you think of it, if the audience is owning that ten-year bond at 1.6%, and you bought a ten-year U.S. treasury, if you think of it as if you’re walking up and down Grant Street in Pittsburgh, and you say, “Hey, I’d like to sell my $100,000 bond and it’s yielding 1.6%,” other people walking up and down the street are saying, “Hey, you know, Jim, I can get 2.6%. I’ll buy your 1.6% bond, but yield rate adjusted, I’ll pay you $85,000 for it.” So, that’s what has really, really shocked a lot of people is this big spike in interest rates.
Jim: All right. So, you can really take a…so when people think they’re being safe by investing in long-term bonds, they can actually lose serious amounts of principle, and that’s just in a couple days on a one percent. And, if we have some type of inflation where the interest rates really go up, you can lose maybe 25%, 35% or more of your principle on money that you thought was your safe money.
P.J.: Yeah. Yeah, you thought it was safe money. And even forget about corporate bonds. You might think back to 1994. We had a real bad year in the bond market with rising rate environment. Long-term government bonds, these aren’t corporate bonds. Long-term government bonds took a face value hit of about 21%. Now, the interest, the coupon in that base, it was 7%, but even if you took the 7% plus and the 21% minus, you were still down 14% in one year on government U.S. treasuries. Albeit, they were thirty-year bonds, but that’s the type of hit you can take in a rising interest rate environment.
Jim: Well, I think that’s important because I do have clients and investors who sometimes think, “Oh geez, I’m really afraid of the market. I want to keep things safe. I want to put everything in CDs and government bonds.” And what you’re saying is, that’s not safe at all, that they could take as big a hit or a bigger hit than the market.
P.J.: Yeah. We call that ‘losing money safely,’ or ‘losing money slowly.’ So, we’re not building those types of portfolios!
Jim: All right. So, your idea is rather than having a ten-year bond where you can really get clipped hard, is to have a short-term bond, give up a little bit of yield in the short-term, but be able to get in and out quickly if you want to and not commit yourself and not lose a lot of face value on your bonds. Is that fair?
P.J.: Yeah, that’s correct.
Jim: All right. The other thing that we have talked about that is apparently brand new research, and I don’t even know how far it is across the country that this has been talked about, but there is a term called the ‘direct profitability premium,’ and could you tell us a little bit about the direct profitability premium and what that means, and what opportunity there is for some of the listeners to enjoy the direct profitability premium?
P.J.: Yeah, Jim, that’s a great point. For decades and decades, since I founded the practice in 1989, there’s basically…and the audience may be surprised to hear this, but there have only historically been three reasons to invest in the stock market. You’ll hear a lot of sales pitches, etc., but there are only three reasons. One’ll be referred to as the “equity premium.” That refers to the stock premium. If the audience can think of stocks being on maybe ladder rung number four and bonds being on ladder rung number one, there’s been about an 8% spread for the last 85 years of stocks doing better than short-term CDs. The next one would be small stocks doing better than large stocks. They provide an additional premium and then value stocks doing better than growth stocks. They provide an additional premium as well. So, if you want to invest your portfolio, number one, you invest in stocks, number two in small caps and number three in value. So, it’s no surprise over the last 85 years, the best performing U.S. domestic asset class, as far as indexes go, for example, has been U.S. small value stocks. So, they’re in stocks. They’re small in their value. But recently, Dimensional Fund Advisors, the DFA, have come up with a number of other premiums in the market. And the interesting part about this is for us investment geeks, so to speak, there hasn’t been an identified premium since about 1992 when the value premium was brought to the forefront from the academic community, and recently, we’ve got the direct profitability premium. I don’t want to have the audience’s eyes glaze over and put them to sleep or anything, but it’s a way that the DFA and the academic community are going to be able to access, and it’s a higher line item. It’s not net income, but it’s a higher line item, the DFA, because one of the biggest questions we get asked, Jim, as you know, is we’re looking at indexes. We get a lot of clients that come to us who are interested in Vanguard or invested in Vanguard…like, you know, “How is DFA beating these Vanguard funds?” I mean, DFA’s outperformed the Vanguard small cap index over the last 31 years by about 1.6%, Vanguard or the Russell 2000, and they’re constantly asking us. I was at a meeting earlier today and a gentleman’s asking me…he’s an engineer from a company downtown in Pittsburgh, he asks me, “You know, how’s DFA beating the Vanguard indexes in the indexes?” You know, and it’s just because of a reason like this. They’ve been in the forefront since the 1960s of the academic research. They have no conflict of interest. They’re a fiduciary perspective, whatever’s in the client’s best interests, and so this is very exciting for us, that this is the first new premium that we’ve seen come to the forefront. So, what DFA’s going to be doing, for example, Jim, is, for lack of a better word, sprinkling this premium within the existing portfolio, so we should expect a higher rate of return, and also setting up new direct profitability asset classes, and this, I think, will be common in a few years where you say we’ve got U.S. large value, U.S. small value, we’re gonna have U.S. large direct profitability, U.S. small direct profitability. And what’s exciting about this is for decades, we’ve been looking, as advisors, that what is DFA gonna come up with? We’ve got all unique proprietary indexes, everything except for the S&P 500, and the new direct profitability U.S. large cap has an expected outperformance that they’re going to add value, and also, basically, track the S&P by 95%, let’s say, with a correlation.
David: Well, you know, on that, let’s take a quick break, and if you have questions, if anybody else has questions for P.J. and Jim, call the KQV studios at (412) 333-9385.
David: And welcome back to the Lange Money Hour with Jim Lange and P.J. DiNuzzo.
Jim: Hi, and before again, we get into the substance for the remaining portion of the show, I do want to repeat the caveat, or the full disclosure. Usually, when I have a guest, it is a national expert, or somebody who I think is adding a lot of information to the table, but I don’t have any skin in the game, if you will. They are a guest, I will often plug a book if I think it’s a good book, but I don’t have any financial interest in whether you buy the book, whether you don’t buy the book, and no financial interest in whether you do business with a guest or whether you do not. That is not true of today’s guest, P.J. DiNuzzo. P.J. is, what I consider, the finest index investor, and I have become a true index fan in the western Pennsylvania area, and he does a wonderful job for clients, and when I became eligible to offer DFA funds to my clients, and I didn’t want to be the money manager. I asked DFA who was the best DFA money manager in western Pennsylvania. There were zero questions. It was P.J. DiNuzzo all the way. Together, we actually have about $60,000,000 that we’ve accumulated, really, in about eighteen months, and he has done a fabulous job. He does unbelievably detailed work. We’re talking about budgets down to the cable bill that will help him do a better job of asset allocation. He doesn’t do one asset allocation per client, like a 40/60, he will do four or five on, “Where are you gonna get your money in the short term?” Well, that better be cash and CDs. “Where are you gonna get your money in the longer term?” And then, actually, multiple portfolios. He does a personal balance sheet, a personal retirement statement; really, he has done a wonderful job. We have 100% retention, meaning not one client that has worked with the combination of me and P.J. has left, but P.J. and I do share fees. So, I am not independent with P.J. and it’s only fair that I disclose that to the audience. So, P.J., you had just talked a little bit about the direct profitability premium, but a couple things that you said really kind of perked my interest. You said that value outperforms growth. You said that small outperforms large. And then, during the break, you mentioned that international outperforms U.S., and emerging markets outperform international. What impacts do those long-term studies that you alluded to have for the investor and how has DFA taken that into an account where perhaps Vanguard has not?
P.J.: Yeah, Vanguard’s done a great job, Jim, but I’ll focus on DFA, who sort of started the entire index wave. What we would say is, you know, what the benefits of these are is building the best portfolio possible, taking all the premiums that the market has available and incorporating those into the portfolios, and if the audience can think of, you know, really, we’re talking about Nobel Prize winners and institutional portfolios. What are these big foundations, endowments, these big Taft-Hartley union pension plans doing? How are they investing? But at the end of the day, a higher rate of return with a lower rate of risk is going to allow you to stay in your portfolios, and a higher rate of return over time means that you and your family are going to enjoy more vacations, have a nicer residence, be able to provide better gifting for your children, better education. So, there are tangible benefits at the end of the day. It’s certainly not an esoteric conversation. There are tangible benefits for the audience members by investing their money as wisely and as well as possible, and from the previous caller that we had call in, and I am sympathetic to that, and I do appreciate that Dalbar, a company out of Boston, Massachusetts, went back and looked, Jim, at the average investor. What was their experience? They looked at all the accounts: E-Trade, Scottrade, Fidelity, Schwab, etc. The average individual managing their own portfolio the last twenty years though the year-end last year December 31, 2012, their average rate of return was 4.25%, people managing their own portfolio. Whereas, the S&P 500 alone was materially over 8%. And so, I’m not disagreeing that individuals have had bad experiences, but I’m just merely proffering or suggesting that there’s better ways of doing things. What the hierarchy that we’ve seen over time, Jim, and over the last twenty years, the clear hierarchy is the lowest rate of return has been individual investors managing their own portfolios. The next highest rate of return, if an individual investor only had one decision, manage this money myself or give it to an active money manager, American Funds, Zero Price, Putnam, Oppenheimer, etc., you’re a lot better giving it to a professional money manager. They’ve done better, but they, again, in turn have underperformed the indexes, just a standard S&P 500, Russell 1000, Russell 2000. But, again, DFA has been at the top of the pyramid. So, we don’t look at it with DFA, they’re certainly not attempting to beat the indexes, but we just feel that they are the best benchmark. They’re building the best, most strict rules. They’re accessing the premiums the best and achieving the highest rate of return. They have done that as a fact over the last twenty years.
Jim: Do you think the reason that DFA has outperformed Vanguard is because they have done a better job of catching, for example, the emerging market premium? The emerging market is something that a lot of people don’t have in their portfolio. I know you were just quoted in the Post-Gazette where you were saying that people should consider having as much as 10% of their portfolio in the emerging markets, and people go, “What?!? Put 10% in Brazil and China and the Pacific Rim and South America and South Korea?? Is this guy crazy??” But 10%, that could be a fair amount. But do the statistics back you up, and is somebody more likely, let’s say, over the next ten years, to do better by having a portion of their money in the so-called ‘emerging markets?’
P.J.: Yeah, Jim. That’s been a statement of fact. The U.S. market, we’ve got data going back to 1926. Internationally, depending if we’re looking at large or small caps, the date goes back to 1970/1975. For emerging markets, our database starts around 1989, and it has been a fact that if we include emerging markets, we’re going to have a better risk-adjusted rate of return in our portfolio by including emerging markets. So, for the rest of all of our lifetimes, for the listeners in the audience, the highest performing investment in your portfolio would be emerging market investments. They are also going to go go down. So, what we say is, let’s say, for example, in the U.S. market, in the developed markets internationally, the Euro Zone, etc., when they catch a cold, emerging markets are going to catch pneumonia. So, we don’t want too much in emerging markets, but if we think of the typical growth portfolio, 60% in stocks or 70% in stocks, it’s not a real large waiting. So, if we were in a 70% stock portfolio and 30% in bonds, 7% of that overall portfolio would be in emerging markets. So, if the audience wants to think of it like a recipe or a formula, a little bit of this, a little bit of that, you got your favorite marinara sauce, if you just take out a couple dashes of this, a couple pinches of that, it’s not quite as good as it is. So, that’s really the purpose that emerging markets serve in that recipe or formula.
Jim: Well, I think that’s an important point because I think a lot of people don’t understand the stock market is not just…you know, you’re playing the horses and there’s nothing behind. These are actual, real companies, and there are good, profitable, real companies that don’t happen to be based in the United States, and that what you are, in effect, buying, is a company that might be based in Brazil or China or in the Pacific Rim or South Korea or South America, and some of these companies can be purchased at a low price and that, over time, will do well. Is that a fair statement?
P.J.: Yeah, Jim, that’s a fair statement. Right now, if we looked at the total globe, as far as a market capitalization, what we call, about mid-40% of the entire investible universe is right here in the United States. So, it’s actually more than 50% of the investments available are outside of the United States. But still, the best split for risk adjusted, for the sweet spot for your portfolio, would be for whatever you’re going to put into stocks, put 70% into the U.S. and domestic, and 30% into international. So, 70% U.S., 30% international, and the way you’re able to get away with that, the sort of difference in the allocation, is with the 70%, you have a lot of companies. When you and I were growing up, there were certain companies that 80-90% of their sales were in the U.S. But you take a look at Coca-Cola sales, everybody knows now that household names across the country that we grew up with are…60-70-80-90% of their sales now are ex-U.S., outside of the U.S. So, a lot of these multi-national companies that everybody owns in their house, if you look around your living room, your kitchen, your dining room, these products on the shelf and in your refrigerator, the majority of their sales now are outside of the U.S. even though they’re domestically based.
Jim: Well, isn’t that an argument that says that the U.S. is doing business all over the world, so why bother taking the risk of having a company that isn’t based in the U.S.?
P.J.: Yeah. Well, I mean, that could be a point, but the point that we look at when we take a look at, for example, emerging markets, would be materially higher expected rates of return. International small cap has, let’s say, a higher expected rate of return and it has done so since 1970. Emerging markets have an even higher expected rate of return. And what’s really happening here, Jim, is it’s the cost of capital story. It’s the same thing if the audience thinks of why, for the last 85 years, have U.S. large stocks done 9% and U.S. small stocks done 11%? Because they have to provide a higher rate of return. There’s not going to be investment in small stocks. They bounce up and down a lot more. More of them go bankrupt. And it’s the same story in the emerging markets. They’re really fast growers. There’s a lot of volatility there, but again, the rate of return has been a few percentage points above even our U.S. small stocks the last quarter century.
Jim: All right. Well, let’s say that we accept this premise that it makes sense to have certain portions of our portfolio invested in assets that are inherently riskier because they have a higher rate of return. Is one of the ways to reduce the risk of some of these higher risk portions of your portfolio, for example, like emerging markets or even small cap, to own an index fund that has many of these companies? So, if one or two of them do go belly up, you’re not going to lose your shirt.
P.J.: Yeah, Jim, yeah, great question. It’s a two-part answer, sort of two questions within there. The first one would be regarding, years ago, really it strikes back to Harry Markowitz, University of Chicago Nobel Prize winner, and the thought for years was well, if you have a risky investment and another risky investment, you put them into a portfolio. Sort of, in layman’s terms, you can have a twice as risky portfolio. But what Harry Markowitz found, from the University of Chicago, was if you have investments, even if they’re both risky, and they have a low correlation with each other, you can not have a higher rate of return from the portfolio with a lower risk level, and that was really the dawn of modern portfolio theory, “MPT”, Harry Markowitz from the University of Chicago. So now, with the same story, is as far as incorporating these assets, and that’s what we were just saying was that emerging markets do have a higher volatility. They also have a higher expected rate of return by the fact that they have a low correlation to the U.S. market. Actually, when you put this entire recipe or formula together…now, the best way to buy them is through an index fund. We’ve seen again, Jim, over the last ten years, the average index, U.S. large, small, international, emerging market, on average, 75% of the time, the indexes are outperforming the average active manager. So, we tell folks, “Why try to go out and find a needle in a haystack?” There will be one out of four active managers who outperform their index, but you don’t know who they are ahead of time, and very, very rarely do they repeat that subsequent 10%, the ten-year period.
Jim: What about just looking for an active manager that did really well for one or two years, or even a sector that did one or two years, and then shifting your money to the ones that did well? Is that a viable strategy, or does that not work out too well? That’s kind of a loaded question!
P.J.: That’s a loaded question, but…
David: John Bogle had a lot to say about that!
P.J.: Yeah, it would work if…and I do believe in God, so I’ll say this, but it would work if God ever created that individual, but no one’s been created who’s able to read tomorrow’s newspaper. So, nobody knows when to move in or out of these asset classes. We just know what the numbers are. We show an image to prospective clients when we talk to them, and we say, “What does the average person buy when they buy a new mutual fund?” They’re buying mutual funds that have performed in the top 25%. Over the recent ten-year period of time, if you went back and looked at the mutual funds that did the best, over the recent five-year period of time, he says, “I’m going to buy one of these good performers,” only 8%…
P.J.: …continued in the next period. 10% of those continued in the second. So, 8% got an ‘A’ on the report card, 10% got a ‘B,’ 20-some percent got a ‘C minus,’ 30-some percent got a ‘D,’ and I think 15% went out of business. So, you could pick a mutual fund that had been in the top 25% performance, and 15% of them were out of business within the next subsequent five-year period of time. So, it’s really, really difficult. There hasn’t been any way that anyone’s found to be able to hop in and out. You know, the best example I can give you, Jim, is we show individuals all the time, Mr. Bill Miller, you know, we give respect where respect’s due, Warren Buffett, the best stock picker of our lifetime, he’s been asked a million times how would you recommend investing? He says buy low-cost index funds. Peter Lynch from Magellan Funds says there’s no advantage to the hot hand, etc. So, we look at Mr. Bill Miller from Legg Mason Value Trust, we just cut to the chase. You know, we’ve got an image we show prospective clients in our continuing education, and he has the longest track record in history for beating the S&P 500. In the entire couple of decades-plus period of time, he managed the Legg Mason Value Trust Fund, he beat the S&P 500 by, I think, .99, let’s just say 1%, but the additional risk he took on, the standard deviation was higher, but even with that…so, we tell folks that’s the best of the best of the best, the longest track record in history, beating the S&P, and he beat it by barely 1% over his entire history. Everything else is worse than that. So, you know, you’ve got a lot of underperformance, which gets back to what we talked about earlier, and we tell the audience we would recommend DFA Dimensionals, we said, but if you’re going to do it yourself, as Jim and I have said before, if you’re not fit to delegate your portfolio, go to Vanguard and build an all-index portfolio with Vanguard.
David: Well, before we take the break, I wanted to ask, where do I get this DiNuzzo Marinara Sauce?
P.J.: That’s a family recipe! That’s from Naples.
David: All right!
Jim: I’ll answer that one. If you have an interest in DFA, and by the way, you can’t go out and get DFA on your own. You have to get it through a DFA advisor, and again, I could put a lie detector test on. I believe that P.J. DiNuzzo is THE best DFA advisor, or any index advisor, that I certainly know, and I know probably thousands of financial advisors, and you want the combination of the Roth IRA conversion analysis, the Social Security analysis, the tax planning, the retirement planning that our firm does, you can get the combination of our firm and P.J.’s firm by contacting our firm, which is at (412) 521-2732, or our website at www.paytaxeslater.com. Does that answer your question, David?
David: Well, that answers my question, but this next spot does, as well.
David: And welcome back to the Lange Money Hour, with P.J. DiNuzzo and Jim Lange.
Jim: One of the things that a lot of listeners and a lot of clients want is they actually want kind of an one-stop shop where somebody is taking a look at their IRA planning, their Roth IRA planning, what they are doing with Social Security, their income tax planning, possibly tax preparation, as well as actually investing the money, preferably using low-cost index funds, and one of the things that I had mentioned in full disclosure is that the combination of our firm, that is the Lange Financial Group, and our affiliated firm, the Lange Accounting Group, is that for clients, we actually do that type of work. P.J. actually does the investments, and the charge is, depending on how much is invested, is usually 1% or less, and people are getting the benefit of our firm, using the Roth strategies, Social Security, tax planning, estate planning, etc., and P.J.’s firm actually doing the investing using low-cost index funds with Dimensional Fund Advisors, and the combination is something that is very attractive. And I know that there’s sometimes, maybe, some overlap in some of the areas that we cover, because P.J. himself is not just an investment guy. He is a CPA. He has a Master’s in tax. Do you find that people have a need for just, let’s call it, personal financial planning, as well as investment planning, that the combination of our firm and your firm actually handles quite well?
P.J.: Yeah, Jim, that’s one of the most common positive comments that we get regarding feedback from individuals, that if the listeners can think of your…if you’re in your automobile, especially, it’ll be a little bit easier if you’re sitting at home, if you’re sitting in a living room or dining room and you think of that as your entire personal financial world, what you would be concerned about is “Is there any dark corners in my personal financial world? Is there anything that I don’t know about, that I’m not handling, I’m not taking care of properly?” And if you think about, what you had mentioned, Jim, in our relationship, I would offer to the audience, in your personal financial world, of the four quadrants, or four corners of your room, one certainly is investment management and everything to do with investments. The other one we would suggest is financial planning, retirement planning, retirement income planning, and college planning. So, we handle, with DiNuzzo Index Advisors, all areas of investment management and all areas of planning, and it works out great, Jim, with our relationship with you and your firm, you’re experts on the tax planning, tax preparation, especially estate planning, wills, trusts, and everything that goes along with that, and especially, I think, you probably, as far as my experience, have done more Roth IRA conversions than anybody I know of in Pittsburgh or east of the Mississippi, for that matter! So, really, what individuals like, and I hear this all the time, Jim, I’ve heard it a couple times within the last couple of weeks alone, is, you know, I feel very comfortable and I’m very happy with this, and I know between DiNuzzo Index Advisors and Lange and his team…and Jim’s got an army: He’s got CPAs, attorneys, and estate planning attorneys in his office. Between what we do and what Jim does, I feel that we have a lower probability for anything falling through the cracks than any other structure that I know of in southwestern Pennsylvania.
Jim: Yeah. The other thing is what’s really nice for me is that you and I see eye to eye on the way things should work. So, sometimes, I’ll have a client…for example, we might be doing an estate plan for somebody, and they might have a money manager, or somebody who is at one of the wire houses, and they don’t see things the way I do. So, for example, I’ll say, “Well, you should be spending the money that you already paid tax on before you’re spending your IRA money.” And they say, “Well, no, my guy said that it’s better to have a balance of IRA money and not IRA money, and since I have more IRA money, I’m going to take money out of my IRA,” and I’m thinking, “No! Look at the numbers!” And you and I are always on the same wavelength of that kind of thing, and what is really nice for, I think, people are not only getting the right advice, but they don’t have to decide between who to listen to, let’s say, the tax advisor or the tax preparer or the estate planner who is saying one thing and the money manager who is saying the other versus “Oh, okay, well geez, these guys are in sync,” and on the off chance that we would not be, frankly, what I would do is I would get on the phone with you and work it out and then have a united front to the client so the client doesn’t have to pick between two competing views, rather they get the best view. And frankly, I can’t even remember when that happened because we have been on the same wavelength for so long.
P.J.: Yeah, Jim, that’s a good point, and if we think about that, I can just give the audience a real life example. You said we really work seamlessly and I think a lot of it is the common ground, you know, congruent interests regarding you’re a long-time CPA, as well as I, and you know, putting client interests first, the fiduciary standard. But just think about what you just said, Jim, was in our case, let’s say we’re handling the investments, we’re handling all the planning work, but think about that other corner of the room: the tax planning and tax preparation. As you yourself know, Jim, I’ve seen a steady twenty-year decline in quality of tax preparation and tax planning, because let’s think about the people that are preparing taxes. They’re out there trying to dabble in investments. They got annuity licenses. So, you think you’re going to your tax preparer and you’re going to get your 1040 completed and they’re pitching you an annuity, or they’re pitching you some kind of other investment. You’re like, “What’s going on?” So, they turn into a jack-of-all-trade, master of none. And the other corner, in the estate planning corner, as you said, with you and I looking at the same information, we’re sharing balance sheets, cash flows, planning, etc. We’ve talked to a lot of individuals, a lot of clients, if we’re just, again, managing the investments and the planning work, they’ll come back to us and tell us, “Well, I found this estate planning attorney and he’s gonna draw this great plan up and everything,” and I can’t even tell you, Jim, how many times just in the last year or two, I can’t count even on both hands on my fingers the hundreds of thousands of dollars that estate planning attorneys have been off regarding building an estate plan. And I just don’t know…well, you know, you missed this $300,000 here and you missed $600,000 there, and that, again, is the seamless relationship. And again, I’m just speaking the facts here regarding what you’re covering and what we’re covering…it’s a lot of things, and I think it would be the same way in your point, you’re saying that hey, you’ve got everything covered, but when some of your clients are coming back from what they’re hearing from the investment manager, it’s the inverse of the challenges that we see on our side of the practice, as well.
Jim: Yeah, and my big thing is, you know, one of the things that, frankly, our office can do, or can control a little bit better than your office, is we can control the tax planning, and P.J., as good as you are, you can’t really control the investments, and you don’t know what’s going to happen in stocks. So, our big thing is, to get people doing certain strategies, even little things like a high income earner putting money in a non-deductible IRA and then converting it to a Roth IRA the next day, so that we get an extra $12,000 a year in income tax-free invested money when they didn’t know they had that opportunity, or money going into a Roth 403(b). The big issue that you had mentioned earlier, that I was responsible for a lot of Roth IRA conversions, and frankly, I would rather not be known as the guy who does Roths all the time. I would rather be known as the guy who crunches numbers and then recommends the optimal course, which does happen to be Roth. But even that, you will like the interplay here, and let’s just use this as an example. Let’s say that I come up with a recommendation for a client, and I said, “Okay, over the next three years, I think that you should convert $50,000 a year to your Roth IRA.” And let’s say, the client says, “Well, that sounds okay.” And then, let’s say that you actually do the mechanics. Are you going to invest that Roth IRA any differently? In other words, is this just like two ships floating in the night that kind of ignore each other, or are you actually going to invest that Roth differently than other monies?
P.J.: Well, that gets back to when you said, Jim, the bucket approach, earlier, and like I said, it’s great that we’re working hand-in-hand. Whenever that happens, it’s generally a seamless transition over to us, and that Roth money is great for, like, high growth when we’re taking a look at money that’s going to be passed on to the children or grandchildren. And, as you mentioned, you know, the high degree of customization we have between your practice and ours in the investment portfolios, our average client who is retired has, on average, three asset allocation strategies. Some clients have four or five, but on average, we average at least three: one for that food, clothing, shelter, healthcare and transportation; another one for your discretionary assets; and a last one for your quality of life/legacy. And that’s why we love the Roth IRA conversion we’re doing…because we fit them into that top bucket, and that’s gonna provide hundreds of thousands of dollars on average to the heirs in that family.
David: Well, you know, we’ve run out of time. We could keep listening here, but we want to say thanks to P.J. DiNuzzo. You can reach him directly at his website, www.dinuzzo.com. Thanks to Jason Gruber, our in-studio producer, and program coordinator Amanda Cassady-Schweinsberg. As always, you can hear an encore broadcast of this show at 9:05 this Sunday morning, here on KQV, and you can always access the audio archive of past shows, including written transcripts, on the Lange Financial Group website, www.paytaxeslater.com, and while there, check out the series of video clips from Jim’s interview with John C. Bogle, founder of the Vanguard Group. You can also call the Lange offices directly at (412) 521-2732. And finally, please join us for the next edition of the Lange Money Hour on Wednesday, July 17th at 7:05, when we’ll welcome back another industry investment giant, Yale University, Professor of Finance, Dr. Roger Ibbotson, to the show.
James Lange, CPA
Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania. He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again. He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans. His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans. Jim’s advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger’s Retirement Reports and The Tax Adviser (AICPA). Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.